Fitch Ratings says that over the next few years it expects M&A to remain high on the agenda of global pharmaceuticals companies as they seek to counteract sales and profit declines due to upcoming patent expirations.
“Fitch believes that the rated pharmaceuticals companies most exposed to operating challenges over the next three years and benefitting from deep pockets - Pfizer Inc, Eli Lilly Co., Merck & Co, Bristol-Myers Squibb Company and AstraZeneca PLC - may be tempted to increase M&A expenditure beyond their normal budgets for bolt-on acquisitions,” says Britta Holt, a Director in Fitch’s Corporates group in London. .
Almost all of the large, rated pharmaceuticals companies favour small and medium-sized targeted acquisitions, with a focus on specific pipeline projects, specific technology, or portfolio or geography gaps rather than mega-mergers.
Fitch calculates that of the 82 $1bn-plus acquisitions in the pharmaceuticals industry over the past 10 years, almost 50% (40) have been announced since 2009 – with the patent cliff imminent. The value of these acquisitions was half ($358bn) of the total value of acquisitions over the past 10 years ($710bn). Since the emergence of the patent cliff Pfizer, Merck, Novartis AG, Roche Holding Ltd, Sanofi SA and Johnson & Johnson Inc., chose to pursue large acquisitions (above $15bn), while other pharmaceuticals, such as BMS and Amgen pursued smaller, more targeted acquisitions, despite operating challenges ahead, and accepted that they faced a period of declining sales.
In terms of the ability to cope with (partly) debt-financed acquisitions, the track record of Fitch-rated pharmaceuticals companies suggests that the companies are able to absorb even large acquisitions without prompting downgrades of more than two notches.
Despite the M&A potential, Fitch expects global pharmaceuticals to remain one of its highest-rated industries. The reasons include superior cash flow generation, large cash balances and strong liquidity – driven by high unsatisfied medical needs, favourable demographics, technological advances and the persistence of chronic diseases.
In the event that companies decide to significantly change their financial policies, Fitch believes that the ‘A’ rating category, ensuring access to the tier-one commercial paper market, will generally be the lowest category that the agency assigns to large pharmaceuticals companies.
For details, see the full Fitch report M&A Pressure to Persist for Global Pharmaceuticals Companies.
Performance of the US banking industry will continue to be weighed down by elevated losses from residential real estate exposure, according to Fitch Ratings.
Fitch estimates that the top 20 banks could incur aggregate losses in excess of $80 billion on home equity and one to four family portfolios over the next three years.
This estimate represents a loss rate of 5.1% on aggregate loans of $1.6 trillion, compared to a cumulative historical loss rate of 8.4% since 2008.
While Fitch expects further deterioration in residential loan portfolios, current ratings already reflect the assumption that losses will remain above historical levels for several years. Each bank’s ratings have a cushion above the base case losses outlined in today’s report. However, if losses in a bank’s home equity and/or one to four family portfolios start to approach Fitch’s stress scenario, its ratings would likely come under negative pressure.
US banks’ exposure to home equity loans is one of Fitch’s top concerns. Most of these loans are on bank balance sheets and are concentrated at the largest institutions. As a majority of them are subordinated, performance remains very much leveraged to further home price declines and potential principal reduction initiatives. Therefore, Fitch believes there is still a reasonable probability that losses in these portfolios could be material.
Large institutions with national portfolios generally tend to have worse credit measures than their regional peers. Fitch partially attributes this to acquired portfolios and looser underwriting standards in some cases. Often, the larger banks have more capital, reserves and earnings capacity to absorb higher losses.
According to Fitch’s Sustainable Home Price model, national home prices in the US may decline by approximately 8%-10%, in real terms, over the next several years. Mortgage delinquency rates have improved modestly from their peak in 2010 but remain elevated. Fitch expects delinquency measures to remain stagnant, as a reduction in new delinquencies has been tempered by a slowdown in foreclosure timelines and continued pressure on home prices.
For more see US Housing and Bank Balance Sheets
Oxford Analytica says a ‘hard landing’ of China’s economy is potentially more dangerous for Latin America than the euro-crisis.
Excerpted from INTERNATIONAL: Latin America faces limited EU risk
After a vigorous recovery from the 2008-09 global crisis, Latin America’s economies slowed down in 2011. Deteriorating global conditions and cooling domestic demand, particularly in Brazil, contributed to lower growth rates. GDP expansion will again be moderate this year, and policy could become more expansionary even if most governments have less room for manoeuvre than in 2008-09.
A worsening of the euro-area crisis would affect Latin American countries through several channels, including a reduction in exports to the EU, falling commodity prices as a result of further global slowdown and a decrease in lending from euro-area banks.
Some countries, such as Argentina, would be hit particularly hard, while the effect on Central America and Mexico would depend more on how European developments affect the United States. However, overall a sharp deterioration in Latin America’s economic conditions is not probable — unless China suffers an unlikely hard landing.
Oxford Analytica expects central banks to expand their quantititave easing activities to include riskier assets.
Excerpted from INTERNATIONAL: QE will move beyond ‘risk-free’ assets
A focus on risk-free assets has limited the effectiveness of QE in developed economies, but central banks will become more ambitious in their use of such programmes.
Among their options is purchasing securitised loans from the banking system, representing claims on both private non-financial businesses and households. Indeed, the US Federal Reserve has already done so by purchasing mortgage-backed securities.
Yet expanding central bank balance sheets through conventional purchases of domestic securities requires a political balancing act. Critics accuse central banks of ‘debasing’ the currency and argue that QE has little power actually to boost activity.
The problem is that, thus far, most QE has focused on buying risk-free bonds – ie, those of the government. Aside from directly reducing the interest rate on these — and thus the price of credit generally — this does little to increase the flow of credit, since banks are likely to treat their new central bank money equivalently to the bonds they had been holding.
To provide liquidity to the economy more broadly, central banks can take a more aggressive stance, by:
- purchasing private-sector securities directly in the open market;
- purchasing bundles of mortgages and/or business loans from the banking system;
- lending to an off-balance-sheet state investment fund for capital improvement projects; and
- acquiring securities of any type from the non-financial sector, including from quasi-governmental agencies.
European fixed income investors expect the eurozone crisis will persist through 2012, according to a survey by Fitch Ratings.
“48% of survey respondents expect the sovereign debt crisis to continue largely as is,” said Monica Insoll, Managing Director in Fitch’s Credit Market Research group. “A quarter of investors are more pessimistic, expecting the situation to worsen, evenly balancing the 24% who think it will get better or be solved.” A very small minority of 3% optimistically anticipate the crisis will be solved during the year.
The investor survey largely accords with Fitch’s view that the eurozone crisis will persist, be punctuated by episodes of severe financial volatility, and not be resolved without a broad-based economic recovery.
Although the ECB’s December LTRO action boosted market confidence in banks, benefits to sovereigns are viewed as more uncertain. 37% of respondents said the ECB liquidity action in December was “the big bazooka”, reducing the risk of eurozone sovereigns facing liquidity crises. However, 54% said there would only be limited take-up by banks for the purpose of buying sovereign debt. 9% of participants even thought the action could worsen the crisis by increasing the sovereign-banking sector links.
Although the LTRO has eased near-term bank and sovereign funding pressures, it is not evident that banks are using it for large-scale purchases of sovereign debt outside their home countries, nor that it has removed the risk of self-fulfilling liquidity and solvency crises.
Fitch’s European Senior Fixed Income Investor Survey Q112 closed on 31 Jan and represents the views of managers of an estimated $7.1trn of fixed income assets.
Oxford Analytica expects the climate for US-based businesses to improve in 2013, no matter who occupies the White House.
President Barack Obama has proposed consolidating agencies in the federal government to produce a more focused economic and business-friendly policy environment and to cut budgetary outlays — and concurrently to establish a dedicated ‘Trade Enforcement Unit’.
Using Reagan-era language, the president is asking Congress to give him authority to ’shrink’ the size of the federal government measured in number of employees and number of regulations, saving 3 billion dollars over ten years. His proposal is the first major executive initiative to seek a return of this power since a special presidential authority to reorganise government lapsed in 1984.
If authorised, it could reduce the cost of doing business for US-based multinational firms.
A streamlined, single ‘USA Business’ agency emulates a model established by several Asian economies, facilitating exports.
However, the proposed Trade Enforcement Unit is obviously directed at China, and would add to trade tensions with Beijing.
The reorganisation would be most effective at promoting US business and exports if accompanied by corporate tax reform, a Romney priority.
While obviously an election-year ploy to embarrass the president’s Republican opponents — who will reject it, even though it conforms to several of their priorities — the president’s latest business-friendly regulatory simplification proposals likely point to significant post-election reform.
This is a positive sign for US businesses; an administration led by either Obama or Mitt Romney would likely make reducing business costs and facilitating exports a priority in 2013.
More from Oxford Analytica
UNITED STATES: Business climate to improve in 2013
Fitch Ratings warns that persistently low returns on pension assets are a far greater threat to European companies than changes to International Accounting Standards.
Low returns increase the cash companies are forced to put into the schemes to keep them funded, with a direct effect on credit quality. The IAS changes will themselves cause many companies to report higher deficits and weaken their income statements – but not change the underlying economics of the pension schemes.
December 2007-December 2011 data from the UK’s Pension Protection Fund shows an average annual increase of pension plan assets of around 3.6% – much of which will have been accounted for by company contributions above payments rather than asset returns. This compares with an assumed return of 6.4% in 2007 for BT Group, which runs the country’s largest private-sector defined-benefit pension scheme, for example.
The difference between the two growth rates over the period represents £113bn additional funding the UK corporate sector will have to find (using December 2011 actual assets of £1,019bn).
In addition, amendments to IAS 19 “Employee Benefits” will have an adverse effect on some companies’ results. The removal of the corridor approach – an option under the current standard that allows companies to smooth movements in their reported deficits – will increase reported deficits in the vast majority of cases where this option is used.
The other major change, which will apply to all companies with pensions, is that the rate at which expected returns on assets can be booked will be required to equal the ‘AA’ bond yields used to discount liabilities. In most cases this will be lower than current assumed returns. This will result in lower financial income recognised in the income statement.
The effect could be material. For example, BT Group had a blended expected return on assets in the year to March 2011 of 6.35%. This compares with the rate used to discount liabilities of 5.5%. Reducing BT’s asset returns for a year by 0.85% gives a fall in profit of GBP303m – 15% of pre-tax profit.
For details see Fitch: Returns not Accounting Real Threat from European Pensions
Noting the stronger than expected earnings performance of US industrial companies, S&P’s Global Markets Intelligence group sees potential upside in companies such as Southwest Airlines.
We think there are a number of intriguing trading possibilities among industrials CDS. For example, Southwest Airlines Co.’s CDS tightened 37% to 118 bps over the past month, though it is 4 bps wider than a year ago.
As the fourth-quarter earnings season winds down, the percentage of industrials companies beating the S&P Capital IQ consensus estimate was the largest (67.44%) of any of the 10 sectors through Feb. 6. Highlights included results from Caterpillar Inc., which reported $2.25 per share against the estimate of $1.77, and Textron Inc., whose $0.49 per share topped the forecast of $0.35.
A majority of companies within the sector expressed optimism about 2012, with Caterpillar saying, “The 2011 increase in sales and revenues was the largest percentage increase in any year since 1947, and much of it was driven by demand for Caterpillar products and services outside of the United States…We’re expecting 2012 to be another year of good growth.” On a forward 12-month basis, the consensus expects the industrials sector to report the most significant earnings growth of all 10 sectors, at 11.1%.
The GMI research team wanted to see if five-year credit default swap (CDS) spreads for U.S. industrials reflected this bullish outlook. We found that the average spread for corporates in this sector tightened by 11% over the past month, according to CMA DataVision. However, it wasn’t enough to lift the average spread out of speculative-grade territory.
But the average spread for the industrials group does not tell the whole story. Transportation spreads tightened by 30% over the past month and are averaging 70 bps. Capital goods spreads narrowed 31% to 196 bps, and commercial and professional services spreads tightened only 1% to 569 bps.
Excerpted from Credit Market Commentary: Market Derived Signal: CDS Spreads Reflect Earnings Momentum In The Industrials Sector
Fitch Ratings has issued a useful guide to spotting aggressive accounting techniques that companies may be tempted to adopt in challenging times.
Fitch notes that for many companies, 2011 was characterized by a strong performance in the first few quarters followed by a weakening later in the year.
This, combined with a weak outlook for 2012, may prompt some to smooth results and resort to increasingly aggressive accounting techniques to manipulate performance metrics or achieve compliance with target ratios and covenants.
Key points from the report:
Audit Does Not Replace Analysis: A clean audit report from a well regarded audit firm provides a good starting point for financial analysis. It should not, however, prevent analysts from applying their professional scepticism. While auditors are the first line of defence and serve as a deterrent, a principles-based IFRS accounting framework gives management a great deal of flexibility in making accounting policy choices.
Estimates Prevail: The objective of accounting principles is to provide a true and fair view of a company‘s financial performance during an accounting period as well as its financial position at year end. Estimates are a major input into all accounts but also increase the scope for manipulation while still playing within the letter of the law. Breaking the rules – through fraud or illegality – is far less widespread than ―creative‖ accounting but opens up more options to manipulate accounts.
Themes and Techniques: The report is less focused on fraud or illegal practices but rather looks at common forms of manipulation of financials within the framework provided by IFRS.
For details, see Accounting Manipulation
The Economist Intelligence Unit expects global economic growth to slow to 3.1% this year from 3.8% in 2011, before rising to 3.9% in 2013. Most of the growth is expected to come from outside the OECD countries.
Key changes in the EIU’s world forecast since December include:
- The Economist Intelligence Unit has raised its forecast for economic growth in the US in 2012 to 1.8%, from 1.3%.
Despite weakening external demand from Europe and Asia and continuing stresses at home, the US economy has been resilient.
- Job growth in the US has accelerated, consumer confidence is improving and households are starting to borrow again. The housing market also shows tentative signs of recovery, and austerity measures by state and local governments are easing.
- The EIU raised its forecast for the average 2012 price of dated Brent crude oil to $100/barrel from $95/b. It increased its expectation of oil consumption growth in 2012 in tandem with the upward revision to our US GDP forecast and signs that China’s economy will avoid a hard landing.
- Tensions over Iran’s nuclear program, which have heightened in recent weeks, will also push up prices in the first quarter, and could cause a catastrophic spike if Iran tries to close the Strait of Hormuz and the US responds militarily.
For details see Country Forecast World February 2012